As we wrote last week, investment assets are usually divided into one of two types: growth or defensive. Last week we discussed growth investments. This week, let’s look at the other kind.

As the name suggests, defensive investments are used to preserve existing wealth. The aim isn’t to make money so much as to not lose it. Whereas property and share investments form the bulk of the growth investment class, defensive investments tend to revolve more around cash-type investments. From the point of view of the investor, things like savings accounts, term deposits, cash management accounts are common ways to make defensive investments, especially directly. A direct investment is one of the investor holds in his or her own name. As well as these direct investments, a defensive investor may also make an indirect investment via a fund manager. This form of investment can include things like term deposits, but also includes things such as bonds or treasury notes.

At base, most defensive investments constitute a loan being made by the investor. You might not realise it, but when you deposit money into a savings account, you are lending the money to the bank which offers the account. The bank then takes that money and uses it to finance its own moneymaking activities – such as providing loans to other people at a higher rate of interest. Same goes with things like cash management accounts and term deposits. Bonds generally constitute a form of loan to whoever has issued the bond – either a government or a trading company.

Defensive investments are sometimes known as ‘cash or cash equivalent investments.’ This is especially the case for those investments that can be quickly converted back to cash, such as a term deposit or an investment in a cash management account.

One of the defining features of a defensive investment is that the rate of return is typically known (or knowable) in advance. This is because the interest rate payable by the borrower is generally agreed prior to the investment. If a specific interest rate is not available, then the method of calculating the interest payable will be agreed. So, interest payable on a cash management account might vary from day to day – but the basis of the variation is known in advance by both parties to the investment.

Because the rate of return is generally known in advance, defensive investments are sometimes known as ‘fixed-rate investments.’ This can lead some people to mistakenly believe that an investment which offers a fixed rate of return is always defensive in nature. This is not the way to decide whether an investment is defensive.

Whether an investment is defensive or not depends entirely on the risk involved in that investment. Defensive assets must be low-risk. If an investment does not have a low level of risk, it should not be seen as defensive, regardless of how its return is calculated. And for cash or cash equivalent investments, the risk associated with the investment has everything to do with the borrower – who the borrower is and how the borrower is going to use the money.

As a result, there are two questions you must ask when considering a defensive investment: (i) to whom am I lending my money? And (ii) how are they going to use it? The answer to both of these questions must leave you with a very high level of confidence that you will get your money back. If not, the investment does not meet the main criterion for a defensive investment – preserving the wealth that you already have.

Without this confidence, you are taking on too much risk. If you are going to take on risk, you might as well do so with the prospect of an increased return – something only a growth investment asset can really provide.

So, if you are considering a defensive investment, please talk to us first. We can help you be as confident as possible of getting your money back when you need it.